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Oil and gas is big business in Norway. The Scandinavian nation is Europe's top oil producer, the world's third-largest exporter of natural gas, and a key supplier of energy to Europe. Norway's oil and gas industry accounts for nearly a quarter of its GDP and almost a third of government revenue.

Spurred by new discoveries in the Norwegian Continental Shelf, oil companies have more than tripled their spending in the country over the past decade. But due to a combination of rising costs, stagnant energy prices, and a challenging regulatory and tax environment, spending is expected to plunge by more than a fifth next year.

Photo credit: Wikimedia Commons.

Norway oil and gas spending to plummet According to a quarterly survey of oil and gas companies operating in Norway cited by Statistics Norway, oil and gas spending in 2015 will land at 182.4 billion kroner, or $30.4 billion, down from an estimated 231.7 billion kroner in 2014 and marking the first such spending decline since 2010. There are a couple of main reasons for this.

One is companies' need to reduce capital spending in the face of operating cost inflation and stagnant commodity prices. For instance, Statoil(NYSE:STO), the largest oil producer in Norway, has pledged to slash spending by $5 billion over the next three years and focus on its most profitable opportunities, as part of its strategy to boost cash flow and improve shareholder returns.

Similarly, Royal Dutch Shell(NYSE:RDS-A), another large operator in Norway, plans to reduce its capital budget from a record $44.3 billion in 2013 to roughly $37 billion this year. To improve shareholder returns, the Anglo-Dutch oil major intends to divest some $15 billion worth of assets through 2015, improve its struggling North American shale and downstream businesses, and focus on high-margin oil projects to boost cash flow.

High taxes The other big reason why Norway's oil and gas spending is projected to plunge is an unfavorable tax climate that greatly constrains the profitability of some existing fields and marginal new projects. in April 2013, Norway's previous Labor-led government unexpectedly reduced the tax-deductible component of petroleum income and increased its special petroleum tax from 50% to 51%, while maintaining a high overall taxation level of 78%.

This move was a key reason why Statoil delayed developing its $15.5 billion Johan Castberg oil field in the Barents Sea. The effective tax increase would add roughly $7 per barrel to Johan Castberg's breakeven cost of development, severely constraining the project's profitability, the company said. The tax increase also prompted Shell to delay its Linnorm field in the Norwegian Sea, which would have produced about 100,000 barrels of oil equivalents per day.

While Norway's new Conservative-led administration has proposed to shield certain projects from the previous government's tax increase, some argue that won't be enough. The Norwegian Oil and Gas Association, an industry trade group, said the newly proposed rules still risk some 80 billion kroner, or $13 billion, worth of planned projects.

The new rules, while not intended to be retroactive, could also apply to new phases of existing projects. For instance, Shell is concerned that its Ormen Lange gas field could be affected. In April, The Hague, Netherlands-based oil major said it would postpone an expansion project at the field, which supplies about a fifth of the U.K.'s gas demand, due in part to higher costs from the tax increase.

Investor takeaway As evidenced by Statoil and Shell's decisions to delay certain projects offshore Norway, taxes are a major factor for oil and gas companies in determining how to allocate capital. Coupled with these companies' capital spending reduction targets, high tax rates greatly diminish the economics of some of their Norwegian projects. As such, they're sure to continue focusing capital on other offshore areas such as the Gulf of Mexico, where the operating and tax environment is much more favorable.

Author

Arjun is a value-oriented investor focusing primarily on the oil and gas sector, with an emphasis on E&Ps and integrated majors. He also occasionally writes about the US housing market and China’s economy.